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Monday, April 13, 2009

The Insolvency of the U.S. Banking System

Is the U.S. banking system insolvent? If so, the current U. S. Treasury bailout plan for banks is doomed since it is premised on the view that the banking system is facing a crisis of liquidity not solvency. PaulKrugman nicely summarizes the thinking behind the Treasury program:

The Obama administration is now completely wedded to the idea that there’s nothing fundamentally wrong with the financial system — that what we’re facing is the equivalent of a run on an essentially sound bank. As Tim Duy put it, there are no bad assets, only misunderstood assets. And if we get investors to understand that toxic waste is really, truly worth much more than anyone is willing to pay for it, all our problems will be solved.

I find it hard to believe this is a liquidity crisis. Take one look at the balance sheet of the U.S. banking system and it is hard to escape the conclusion that the U.S. banking system is insolvent. Both NourielRoubini and Michael Pomerleano examined the banking system's balance sheet and concluded there is an insolvency problem. Here is Pomerleano:

The banking system is severely undercapitalized, with numerous insolvent banks. Clearly a more robust banking system requires far more capital and a robust loan loss reserve adding to the capital cushion. Until the trillion plus of impaired assets are removed and the banking system is recapitalized, credit flows will be restricted. In this context, it is puzzling why the administration is tinkering at the fringes with programs designed to enrich Wall Street. Geithner and Summers need to address the banking problems square-on.

So what exactly does the U.S. banking systems balance sheet look like? Thankfully, Tyler Durden at Zero Hedge went to the trouble of creating a consolidated balance sheet for the U.S. banking system for 2008:Q2. As Felix Salmon notes, the numbers from this balance sheet are "terrifying." I have posted a picture of the balance sheet below. (Click on the figure to enlarge.)

Tyler explains the gravity of the situation as seen in this balance sheet:

The biggest concern is the roughly $8.1 trillion in loans currently on the asset side of the equation, however the other assets, which include $2.8 trillion in securities and $2.5 trillion in other assets should not be ignored. I point out the loans as this is where the vast majority of the "toxic assets" reside. The real question mark is what is the true value of this $8.1 trillion number as the financial system contracts massively. As has been pointed out, banks have taken only about $1.2 trillion in write downs against these assets.

Is that amount of write downs enough?

Not by a long shot if one considers the various guarantee and support programs enacted by the Federal Reserve and the Treasury. In a normal world, the Assets, by definition, should equal the Liabilities plus Shareholder Equity. As nobody knows what the true value of the assets really is, the Bail Out support programs are designed to provide the backing to make it seem like the almost $8 trillion in deposits, the core of bank and thrift liabilities, are not "supported" by toxic assets, or "hot air" to use popular jargon. As presented, the various Bail Out programs now support over 72% of the total liabilities on the balance sheet. The implications of this are staggering: Roubini anticipates the total amount of write downs (in the US) will reach $3.6 trillion, or another $2.4 trillion to go. The revised IMF estimate (which is not the final one by a long shot) estimates $3.1 trillion in total US losses, or another roughly $2 trillion to go. These provisions are optimistic. Why - because through its various implicit and explicit guarantees the administration is saying the total pain could potentially reach $8.8 trillion.

According to Tyler, then, there is only about $1.4 trillion in bank capital with potential write downs ranging from $3 trillion t0 almost almost $9 trillion. That spells an insolvent U.S. banking system. It is also striking that 72% of the liabilities in the U.S. banking system are being supported by the government. With so much existing government support how much different would outright nationalization be? The only downside I can see is that a restructuring of the U.S. banking system could trigger another credit crisis. But either way there is some cost. I say we take the hit now and restructure the banks.